The things I would tell my clients this week
Risk buildup continues. Another bank failed in the US. The Fed is preparing to deliver another rate hike – and perhaps more. And the fight over the US Debt ceiling has begun. Yet everyone seems relaxed around the risk build up.
Partly this is because the Fed will print if something goes wrong. Partly it is because we are becoming anesthetised with bank failures. These happen.
This isn’t market risk. This is policy risk, and it takes a long time for those effects to become obvious. Over the short term, we are as relaxed as regulators and policymakers tell us to be. But strategically, we are weighing policy risk build up against our long-term allocation.
A bank, the Fed, a ceiling and the (short-term absence) of fear
“Be fearful when others are greedy, and greedy when others are fearful”
-Warren Buffet, letter to Shareholders 2004
Another week, another regional bank failure. First Republic, a 37-year-old bank from San Francisco became the third US regional bank and fourth in a row to fail (including Credit Suisse). Apart from the actual day of the failure, curiously a Monday as opposed to the classic Friday, there isn’t much to write home about. First Republic had been on life support since the week after SVB’s failure, with slim chances of recovery. The Federal Deposit Insurance Company (FDIC) stepping in was simply the signing of its official death certificate.
When rates are high, smaller lending organisations may fail. It's part of the game. SVB and Signature have gone under and First Republic followed. Those knowledgeable in financial history will be familiar with the Savings and Loans crisis. Between 1986 and 1995, 3,234 Savings and Loans organisations (essentially banks), closed[1]. This was 2/3 of the market. Yet, the US financial system came out stronger for it. In fact, some of the regional banks that failed as of late are simply the evolution of S&L associations and grew by acquiring failed S&L entities.
And while it is the really problematic entities that failed, the pressure continues throughout the US banking system, with peripheral banks still heavily using the Fed’s discount window.
that the bank was allowed to fail on a Monday instead of a Friday (which would give markets some time to digest the news) suggests that regulators didn’t fear a market backlash. On Monday (the US market was open) stocks barely moved on the news, ending the session nearly flat. The yield on the US 10-year bond inched upward, of course, but not significantly.
What’s more important, the implied market expectations for Fed rates were also unmoved.
The market still expects the US central bank to go ahead with at least one more rate hike. What will be infinitely more important this time around, is the statement, where Jay Powell’s policy team is expected to provide some guidance as to their intentions regarding further rate hikes. Whereas the bond market isn’t pricing in any further tightening, strategists in Wall Street expect that the Fed, which has already acknowledged that credit conditions are tighter, could squeeze in one more hike until pausing. That means that the Fed remains undaunted by bank failures (after all, these happen), or even the fact that interest rates will now be higher than actual inflation for the first time in years bar the pandemic.
But policymakers remain fearless in their fight against inflation, and markets have started to share their sentiment.
And with all that happening, we are closing in on the much-anticipated debt ceiling fight in US Congress. In his 1989 book Secrets of the Temple[2], William Greider points to the perennial disconnect between Wall Street and Washington DC. Just as markets aren’t much good at anticipating electoral results, elected representatives often don’t exhibit insight as to the financial and economic impact of their decisions. Negotiations between House Republicans and the Democratic leadership remain frozen. Each faction is devising legal tactics, all intent to hold global (and local) investors hostage to gain leverage in budget negotiations. Policymakers here too seem fearless of the repercussions. The fact that the Dollar steadily loses ground against gold and perhaps other currencies as a global reserve goes largely unnoticed in the Capitol of the world’s biggest economy.
CDS markets are, naturally afraid, pricing in a US default in the next twelve months, higher than Greece or Italy!
Yet, bond markets remain by and large unperturbed. Lawmakers have threatened us with the debt ceiling so many times, why should this be different?
To go back to the quote at the beginning, Warren Buffet’s quote reminds us to be “fearful when others are greedy and greedy when others are fearful”. By “others”, the Oracle of Omaha meant the faceless market. But policymakers (central bankers, lawmakers) are human and can fall into the same trap too. The relentless pursuit of a singular goal, be it lower inflation or a partisan legislative agenda can render one greedy for victory and fearless of repercussions. As long as a win can be declared, what was broken will matter less. Conflated with the usual short-termism in politics[3], where those in power often fail to acknowledge the consequences of their actions beyond their immediate future or their own term in office, it becomes apparent that policymakers worry less about some things than others.
Bill Clinton’s focus on all Americans owning their home and Ronald Reagan’s market reforms led to the 2007 Global Financial Crisis, well after their term in office. The previous administration’s decision to loosen regulations for smaller banks[4] arguably contributed to the present peripheral banking crisis. So did the (at the time logical) decision to give big checks to all Americans during the pandemic, which led to higher inflation and inescapably higher interest rates.
And the question is, should we be fearful when it’s policymakers that are greedy and not so much the markets?
Historically, the answer is yes but over the longer term. Congress and the Fed have ways to mitigate a debt default if it causes a crisis. And the central bank can always print money and reduce rates if the market is collapsing as a result of a self-induced crisis. Policymakers are bullish and take risks because they presume they have the power to fix the things they broke in their pursuit. But those fixes are usually short-term. This will be reflected on our short-term, tactical asset allocation.
Over the long term, they tend to cause ripples far beyond what we can see today. Lack of trust in the world’s risk-free asset, the US Treasury, is bound to have long-term implications for investors. Banks breaking are bound to change consumer behaviour in ways unforeseen. These risks should be reflected on our long-term, strategic, asset allocation.
This note is not written by a market commentator but by an asset manager with a clear fiduciary duty to fear and investigate the things their clients can’t. This is where we, in this industry, earn most of our management fees. And whereas the motto “we are focused on the long term” appears like a usual cop-out, we are thinking about those repercussions and what their impact will be on our strategic allocation. So yes, we are as short-term bullish as policymakers suggest we should be and as long-term bearish as history tells us to be when potential policy errors are committed.